Fantastic vaccine news and a post-election relief rally has left many credit investors asking, “Is there any opportunity left from here?” We believe the answer is yes. The ink spilled in the marketplace about record low yields due to record low rates overlooks the significant dislocation that remains in COVID-impacted sectors.1 The broader credit market opportunity we referenced in papers earlier this year2 has largely played out, but many COVID-impacted businesses are still trading at levels offering attractive total return to normalization and face cyclical, rather than secular, challenges. These sectors account for only 25% of the high yield market but account for most of the spread widening on the year, despite maintaining meaningful equity market caps. For some of these businesses, enterprise values have recovered fully from pre-COVID levels, despite optically large equity share price declines. Meanwhile, the credit spreads of many of these businesses are still wider on the year, and we believe continues to present a good opportunity to capture excess return in credit.
What COVID Sector Defaults?
While default rates in the market have continued to increase overall, COVID sectors have contributed only 0.4% of the current high yield market’s 6.2% default rate, while accounting for ~25% of the market. In fact, Energy, Retail, and Telecom account for more than half of the high yield market’s defaults this year alone while comprising only 23% of the high yield market.3 However, spread underperformance has created an opportunity to build exposure to many of these COVID-impacted names that boast double-digit total return absent the secular risk of distressed sectors. While many of these businesses will emerge from COVID slightly more levered than pre-COVID due to cash burn and debt issuance (along with equity issuance), there is still substantial equity cushion support before the debt can be impaired. Further, the importance of running a sound balance sheet is likely to be reinforced by management as a priority going forward after flirting with the disaster of this past year.
COVID Sector Credits Are Still too Wide and Attractive
With the meaningful rally in the markets since the spring, we are now only 73 bps off pre-COVID levels.4 High yield spreads are now trading at ~500 bps versus their long-term median of ~550 bps and year-end 2019 levels of 424 bps. Similarly, leveraged loan spreads are now just 60 bps wide of year-end 2019 levels and 20 bps wide of the long-term median for loan spreads.5 While high yield and loans are at least relatively in-line to average historical levels, investment grade bonds are now at a spread of ~110 bps versus the long-term median of ~172 bps, offering very little compensation for investment grade credit risk over Treasuries, comparatively.6
So, where is the dislocation? Despite the significant tightening in credit spreads from the wides this spring, hard-hit COVID-impacted businesses with (and without) public equity market caps continue to trade at meaningful discounts that offer double-digit returns. Many of these COVID-impacted sectors remain substantially wider from year-end 2019 levels and have contributed 61% of high yield’s overall spread widening on the year. As a result, remaining high yield sectors are relatively less attractive because they have seen either spread tightening or minimal widening during this period. As we can see in Exhibit 1, when we strip COVID-sectors out of the high yield market, the remaining 75% of the market has widened out only 39 bps in aggregate versus COVID-impacted sectors still being wider by anywhere from 126-405 bps on the year.
EXHIBIT 1: HIGH YIELD VS. COVID-IMPACTED SECTOR SPREAD CHANGES YTD